How to size up that hot stock tip using the fine print of a prospectus
Your broker calls with a sure-fire tip: Bio-Gizmos & Silicon Waffles is going public. As with many new stock issues, the price is under $10 and the growth potential ''enormous,'' he says. You want a closer look, so he drops Bio-Gizmos' prospectus in the mail.
The tome arrives a few days later, but it may as well be an original-language edition of Tolstoy's ''War and Peace.'' You're no accounting wizard and the prospect of wading through the fiscal hieroglyphics is daunting.
True, a prospectus - required by the government to disclose fully the facts about a company so investors can judge the risks - is exhaustive. Its content has ballooned because companies also now use the prospectus as a protection from shareholder lawsuits. If it's in the prospectus, company lawyers can say they warned you.
But all that information can be quite helpful in separating the hot tips from the bum steers. And it's not as complicated as it may appear.
The following highlights were drawn from interviews with several state securities commission directors and the publisher of New Issues, a newsletter in Fort Lauderdale, Fla.
Start at this section. It is the most straightforward discussion of the company's weaknesses. You may discover that Bio-Gizmos is dependent on one supplier for a key part and how reliable that supplier may or may not be. If the risks discussed, in your view, undermine the future success of the company, you needn't read any further, advises Chris Anderson, director of the Florida Securities Commission.
Here you will find the names and backgrounds of the company's chief officers. Ask yourself such things as ''How much business and educational experience do the managers have in making Bio-Gizmo-type products?'' ''Have they worked for reputable companies before?''
In or near this section should be the salaries paid to management. ''If a company has significant losses and the executives are paying themselves six-figure salaries, you should think about that,'' suggests Michael Unger, director of the Massachusetts Securities Commission (which turned down Apple Computer's initial stock registration 41/2 years ago).
Look first at the section entitled ''Management Discussion of Earnings and Operating Results,'' counsels Glen King Parker, publisher of New Issues. There, management will explain the reasons for ups or downs in earnings and may talk about future growth. Then, turn to the consolidated-income or earnings statement. ''It's not an awesome thing for non-accountants,'' says Mr. Unger. The statement covers the past two to four years and will show how consistent or dramatic sales revenues growth may have been, as well as any profit or earnings.
Use of proceeds
This section discusses what Bio-Gizmos' management plans to do with the money from the stock it sells. If the proceeds are used to pay off loans, rather than buy new equipment or increase the number of outlets, it may be something to consider. Retiring debt is not necessarily a poor use of the funds, because this can help cash flow. But your money may not be going directly into expanding Bio-Gizmos' earnings potential. And sometimes it's to pay off a loan made by one of the company's own officers.
Here you will find out how much the stock you buy will be watered down by the free or less-expensive shares already held by original investors. For example, Bio-Gizmos' founders hold 50 percent of the stock outstanding and they paid nothing for it. When the remaining 50 percent of the shares are sold at $10 a share, the book value of your shares drops to $5 and the Bio-Gizmos principals will make $5 a share on your investment. If the company should go bankrupt the next day, although it's an unlikely supposition, half of your original investment may be lost. Securities administrators say a dilution of 75 percent should be cause for concern.
Litigation or investigations
If Bio-Gizmos has pending a million-dollar lawsuit by a disgruntled customer, you'll find that out in this section. Even if the case appears winnable by the company, court costs could slow the company's growth. Also here will be word on whether Bio-Gizmos is being investigated by the Environmental Protection Agency (or some other government watchdog) for something like waste disposal violations. Cleanup costs or fines might hamper company expansion.
Finally, if you do not understand parts of the prospectus, call the sponsoring brokerage or the company itself. If their answers fail to satisfy you , check with a lawyer, accountant, or financial planner.
You should also be aware that although most prospectuses are filed with the Securities and Exchange Commission or a state securities commission, registration with these agencies is not a guarantee of soundness or approval.
Next month: Cracking an annual report